A. Deconstructing the Market System

It is a commonplace today to talk about the "efficiency"
of the market system: everybody can buy what they need from one
of a large number of competitive sellers, everyone can sell what
they make to one of a large number of competitive buyers (or,
more plausibly, "sell" their time to one of a large
number of competitive employers). Everybody can make whatever
deals they are able regarding the prices at which they buy and
sell.

Two hundred and thirty years ago the Scottish moral philosopher
Adam Smith used a particular metaphor to describe this system,
a metaphor which still resonates today:

...every individual... endeavours as much as he can... to
direct... industry so that its produce may be of the greatest
value.... neither intend[ing] to promote the public interest,
nor know[ing] how much he is promoting it.... He intends only
his own gain, and he is in this, as in many other cases, led
by an invisible hand to promote an end that was no part
of his intention.... By pursuing his own interest he frequently
promotes that of society more effectually than when he really
intends to promote it...(1)

Adam Smith's advocacy in 1776 of the market system as a social
mechanism for regulating the economy was the opening shot of
a grand and successful campaign to reform how politicians and
governments looked at the economy. The past two centuries have
seen his doctrines woven into the fabric of our society. Governments
that followed his path now rule economies that are moe materially
prosperous and technologically powerful economies than any others
ever seen.(2)

Belief in free trade, an aversion to all forms of price controls,
freedom of occupation, freedom of domicile, freedom of enterprise,
and all the other corollaries of belief in Smith's Invisible
Hand are now more than ever the background assumptions for thinking
about the relationship between the government and the economy.
A free-market system, most economists claim and most participants
in capitalism believe, generates a level of total economic product
that is as high as possible--and is certainly higher than under
any alternative system that we have known.(3)
The standard implication drawn from this economic success story
is that in the overwhelming majority of cases the best thing
the government could do for the economy was to leave it alone:
laissez-faire (with exceptions, of course, for well-defined
and narrowly-specified "market failures").

The main reason that it is generally believed that a free
and competitive market system will lead to something worth calling
"optimal" is the dual role played by prices in a well-functioning
market system. On the one hand, prices serve to ration demand:
anyone who is not willing to pay the market price of a particular
commodity because he or she would rather do other things with
his or her (not unlimited) money does not get to consume the
commodity. On the other hand, price serves to elicit production:
anyone or any organization that can produce a commodity for a
cost that is less than its market price has a strong financial
incentive to do so.

You can criticize the market system because it undermines
the values of community and solidarity. You can criticize the
market system because it is unfair--for it gives good things
to those who have control over whatever resources turn out to
be most scarce as society solves its production allocation problem,
not to those who have any moral right to the good things. But
the market system has the powerful achievement of creating the
maximum money amount of social surplus, at least under the conditions
that economists usually assume.

1. Structure of This Chapter

We assume readers are broadly familiar with Adam Smith's case
for the Invisible Hand. The next section deconstructs that case
by pointing out three assumptions about production and distribution
technologies which are essential for the Invisible Hand to work.
We suggest that these assumptions are increasingly unsuited to
the information economy. In the following section we take a look
at some of the things that are happening on the frontiers of
electronic commerce and in the market for information. Our hope
is that what is now going on at the frontiers of electronic commerce
may contain some clues to processes that will be more general
in the future.

Our final section does not answer all the questions we raise.
Instead it raises still more questions. The most we can begin
to do at this point is to organize our concerns in a coherent
and comprehensible framework. By looking at the behavior of people
in high-tech commerce--people for whom the abstract doctrines
and theories that we present have immense concrete reality because
they determine whether or not they get paid--we can also form
some tentative conclusions about what the next economics, and
the next set of sensible policies, might look like.

B. "Technological" Prerequisites of the Market

Modern technologies are beginning to undermine the features
that make the Invisible Hand of the market system an effective
and efficient system for organizing production and distribution.
The case for the market system has always rested on three pillars:
call the first excludability, the ability of sellers to
force consumers to become buyers and thus to pay for what they
use; call the second rivalry, a structure of costs in
which two cannot partake as cheaply as one, and in which producing
enough for two million people uses up at least twice as many
resources as producing enough for one million people; call the
third transparency, that individuals can see clearly what
they need and what is for sale so that they truly know what they
wish to buy.

All three of these pillars fit the economy of Adam Smith's
day pretty well. They fit much of today's economy pretty well
too--although the fit for the telecommunications and information
processing industries is less satisfactory. They will fit tomorrow's
economy less well than today's. And there is every indication
that they will fit the twenty-first century economy relatively
poorly.(4) As we look at developments
along the leading technological edge of the economy, we can see
what used to be second-order "externality" corrections
to the Invisible Hand becoming first-order phenomena. And we
can see the Invisible Hand of the competitive market working
less and less well in an increasing number of areas. This result
is particularly surprising when one considers that most economic
theory suggests that things which make information cheaper and
more accessible should generally reduce friction in competitive
markets, not gum up the works.

1. Excludability

In information-based sectors of the next economy the owner
of a commodity will no longer be able to easily and cheaply exclude
others from using or enjoying the commodity. Digital data is
cheap and easy to copy. Methods exist to make copying more difficult,
but they add expense and complexity. Without excludability
the relationship between producer and consumer is much more a
gift-exchange than a purchase-and-sale relationship.(5)
The appropriate paradigm is then an NPR fund-raising drive. There
is no reason to presume that non-excludable commodities will
get into the hands of the consumers who value them the most.
And--with compensation to the producer determined not by the
purchase-and-sale exchange of money for value but by the user's
feelings of moral obligation to the producer--there is no reason
to expect that production will be as high as it should be to
maximize social welfare.

If goods are not excludable then rather than sell things,
people simply help themselves. If the taker feels like it, he
or she may make a "pledge" to support the producer.
Perhaps the average pledge will large enough that producers cover
their costs. Many people seem to feel a moral obligation to tip
cabdrivers and waiters and to contribute to National Public Radio.
But without excludability it is hard to believe that the (voluntary)
payments as a matter of grace from consumers to producers will
be large enough to encourage the optimal level of production.
Indeed, most of what we call "rule of law" consists
of a legal system that enforces excludability--such enforcement
of excludability ("protection of my property rights,"
even when the commodity is simply sitting there unused and idle)
is one of the few tasks that the theory of laissez-faire
allows the government.

Excludability does not exist in a Hobbesian state of nature:
the laws of physics do not prohibit people from sneaking in and
taking your things. So the police and the judges exist to enforce
it, through penalties for breach of contract and damage awards
for theft of intellectual property. The importance of this "artificial"
creation of excludability is rarely remarked on: fish are supposed
to rarely remark upon the water in which they swim.

We can see how an absence of excludability can warp a market
and an industry by taking a brief look at the history of network
television. During its three-channel heyday in the 1960s and
1970s, North American network television was available to anyone
with an antenna and a receiver because broadcasters lacked the
means of preventing the public from getting the signals for free.
Free access was, however, accompanied by scarce bandwidth, and
by government allocation of the scarce bandwidth to producers.

The absence of excludability for broadcast television did
not destroy the television broadcasting industry. Broadcasters
couldn't charge for what they were truly producing, but broadcasters
worked out that they could charge for something else: the attention
of the program-watching consumers during commercials. Rather
than paying money directly, the customers of the broadcast industry
merely had to endure the commercials (or get up and leave the
room; or channel-surf) if they wanted to see the show.

This solution prevented the market for broadcast programs
from collapsing: it allowed broadcasters to charge someone
for something. But it left its imprint on the industry.
Charging-for-advertising does not lead to the same invisible
hand guarantee of productive optimum as does charging for product.
In the case of network television, audience attention to advertisements
was more-or-less unconnected with audience involvement in the
program.

This created a bias toward lowest-common-denominator programming.
Consider two programs, one of which will fascinate 500,000 people,
and the other of which 30 million people will watch as slightly
preferable to watching their ceiling. The first might well be
better for social welfare: the 500,000 with a high willingness-to-pay
might well, if there was a way to charge them, collectively outbid
the 30 million apathetic potential watchers. Thus a network able
to collect revenues from interested viewers would broadcast the
first program, seeking the applause (and the money) of the dedicated
and forgoing the eye-glazed semi-attention of the mass.

But the process breaks down when the network obtains revenue
by selling commercials to advertisers. The network can offer
advertisers either 500,000 or 30 million viewers. How influenced
the viewers will be by the commercials depends relatively little
on how much they like the program. As a result, charging-for-advertising
gives every incentive to broadcast what a mass audience would
tolerate. It gives no incentive to broadcast what a niche audience
would love.

As bandwidth becomes cheaper, these problems become less important:
one particular niche program may well be worth broadcasting when
the mass audience has become sufficiently fragmented by the viewability
of multiple clones of bland programming. Until then, however,
expensive bandwidth combined with the absence of excludability
meant that broadcasting revenues depended on the viewer numbers
rather than the intensity of demand. Non-excludability helped
ensure that broadcast programming would be "a vast wasteland."(6)

In the absence of excludability, there is no reason to presume
that industries today and tomorrow will be able to avoid analogous
distortions: the absence of excludability leaves potential users
with no effective way to make the market system notice how strong
their demand is and exactly what their demand is for.

2. Rivalry

In the information-based sectors of the next economy the use
or enjoyment of the information-based commodity will no longer
necessarily involve rivalry. With most tangible goods,
if Alice is using a particular good, Bob cannot be. Charging
the ultimate consumer the good's cost of production or the free
market price provides the producer with an ample reward for his
or her effort. It also leads to the appropriate level of production:
social surplus (measured in money) is not maximized by providing
the good to anyone whose final demand for a commodity is too
weak to wish to pay the cost for it that a competitive market
would require.

But if goods are non-rival--if two can consume as cheaply
as one--then charging a per-unit price to users artificially
restricts distribution: to truly maximize social welfare you
need a system that supplies everyone whose willingness to pay
for the good is greater than the marginal cost of producing
another copy. And if the marginal cost of reproduction of a digital
good is near-zero, that means almost everyone should have it
for almost free.

However, charging price equal to marginal cost almost surely
leaves the producer bankrupt, with little incentive to maintain
the product except the hope of maintenance fees, and no incentive
whatsoever to make another one except that warm fuzzy feeling
one gets from impoverishing oneself for the general good.

Thus a dilemma: if the price of a digital good is above the
marginal cost of making an extra copy, some people who truly
ought--in the best of all possible worlds--to be using it do
not get to have it, and the system of exchange that we have developed
is getting in the way of a certain degree of economic prosperity.
But if price is not above the marginal cost of making an extra
copy of a non-rival good, the producer will not get paid
enough to cover costs. Without non-financial incentives, all
but the most masochistic producer will get out the business of
production.

More important, perhaps, is that the existence of large numbers
of important and valuable goods that are non-rival casts the
value of competition itself into doubt. Competition has been
the standard way of keeping individual producers from exercising
power over consumers: if you don't like the terms the producer
is offering, then you can just go down the street. But this use
of private economic power to check private power may come at
an expensive cost if competitors spend their time duplicating
one another's efforts and attempting to slow down technological
development in the interest of obtaining a compatibility advantage,
or creating a compatibility or usability disadvantage
for the other guy.

One traditional answer to this problem, now in disfavor, was
to set up a government regulatory commission to control the "natural
monopoly". The commission would set prices, and do the best
it could to simulate a socially optimum level of production.
While it may have seemed like the perfect answer in the Progressive
era, in this more cynical age commentators have come to believe
that regulatory commissions of this sort almost inevitably become
"captured" by the industries they are supposed to regulate.
Often this is because the natural career path for analysts and
commissioners involves someday going to work for the regulated
industry in order to leverage expertise in the regulatory process;
sometimes it is because no one outside the regulated industry
has anywhere near the same financial interest in manipulating
the rules, or lobbying to have them adjusted. The only effective
way a regulatory agency has to gauge what is possible is to examine
how other firms in other regions are doing. But such "yardstick"
competition proposals--judge how this natural monopoly is doing
by comparing it to other analogous organizations--are notoriously
hard to implement.(7)

A good economic market is characterized by competition to
limit the exercise of private economic power, by price equal
to marginal cost, by the return to investors and workers corresponding
to the social value added of the industry, and by appropriate
incentives for innovation and new product development. These
seem impossible to achieve all at once in markets for non-rival
goods--and digital goods are certainly non-rival.

3. Transparency

In the information-based sectors of the next economy -- indeed,
in many sectors of the economy today -- the purchase of a good
will no longer be transparent. The Invisible Hand assumed
that purchasers know what it is that they want and what they
are buying. If purchasers need first to figure out what they
want and what they are buying, there is no good reason to presume
that their willingness to pay corresponds to its true value to
them.

Adam Smith's pinmakers sold a good that was small, fungible,
low-maintenance and easily understood. Alice could buy her pins
from Gerald today, and from Henry tomorrow. But today's purchaser
of, say, a suite of software programs is faced with needs and
constraints that a metric designed to explain the market for
pins may leave us poorly prepared to understand. The market for
software "goods" is almost never a market for today's
tangible goods, but rather for a bundle of present goods, future
goods, and future services. The initial purchase is not a complete
transaction in itself, but rather a down payment on the establishment
of a relationship.

Once the relationship is established, both buyer and seller
find themselves in different positions. Adam Smith's images are
less persuasive in the context of services--especially bespoke
services which require deep knowledge of the customer's wants
and situation (and of the maker's capabilities)--which are not,
by their nature fungible or easily comparable.

When Alice shops for a software suite, she not only wants
to know about its current functionality--something notoriously
difficult to figure out until one has had days or weeks of hands-on
experience--but she also needs to have some idea of the likely
support that the manufacturer will provide. Is the line busy
at all hours? Is it a toll call? Do the operators have a clue?
Will next year's corporate downsizing lead to longer holds on
support calls?

Worse, what Alice really needs to know cannot be measured
at all before she is committed: learning how to use a software
package is an investment she would prefer not to repeat. Since
operating systems change frequently, and interoperability needs
changes even more often, Alice needs to have a prediction about
the likely upgrade path for her suite. This, however, turns on
unknowable and barely guessable factors: the health of the corporation,
the creativity of the software team, the corporate relationships
between the suite seller and other companies.

Some of the things Alice wants to know, such as whether the
suite works on quickly enough on her computer, are potentially
measurable at least--although one rarely finds a consumer capable
of measuring them before purchase, or a marketing system designed
to accommodate such a need. You buy the shrink-wrapped box at
a store, take it home, unwrap the box--and find that the program
is incompatible with your hardware, your operating system, or
one of the six programs you bought to cure defects in the hardware
or the operating system...

The economics of information is frequently invoked to adjust
the traditional neoclassical paradigm to model for the consumer's
decision as to whether it pays to attempt to acquire these facts:
for example, one can hypothesize that Alice's failure to acquire
the necessary information is evidence of the high cost of the
investigation compared to the expected value of what it might
reveal. So adjusted the basic model retains descriptive power.
But its explanatory power is limited.

4. The Economics of Market Failure

That the absence of excludability, rivalry, or transparency
is bad for the functioning Invisible Hand is not news to economists.(8) The analysis of failure of transparency
now makes up an entire subfield of economics: "imperfect
information." Non-rivalry has been the basis of the theory
of government programs and public goods, as well as of natural
monopolies: the solution has been to try to find a regulatory
regime that will mimic the decisions that market ought to make,
or to accept that the "second-best" public provision
of the good by the government is the best that can be done. Analysis
of the impact of the lack of excludability is the core of the
economic analysis of research and development. It has led to
the conclusion that the best course is to try to work around
non-excludability by mimicking what a well-functioning market
system would have done by using the law to expand "property"
or through tax-and-subsidy schemes to promote actions with broad
benefits.

But the focus of analysis has always been on overcoming "frictions":
how can we make this situation where the requirements of laissez
faire fail to hold into a situation in which the Invisible
Hand works tolerably well? And as long as the Invisible Hand
works well throughout most of the economy this is a tolerable
strategy: a finite number of government programs and legal doctrines
to mimic what the Invisible Hand would do if it could function
properly in a few distinct areas of the economy (like the natural
monopoly implicit in the turn-of-the-twentieth-century railroad,
or government subsidization of basic research). Such a strategy
can achieve reasonable performance, as long as the industries
and commodities that do not fit the Invisible Hand paradigm are
an easily-identified, relatively-small subset of the economy.

C. Out on the Cybernetic Frontier

Today, problems of non-excludability, of non-rivalry, of non-transparency
apply to a large range of the economy. What do we do when the
friction becomes the machine? Usually, economists proceed by
a process analogous to perturbation theory: first they solve
the simple problem, in which the market works well, and then
they consider how the solution changes in response to small steps
away from the conditions necessary for the simple solution to
hold. In the natural sciences perturbation-theory approaches
break down when the deviations of initial conditions from those
necessary for the simple solution become large. Does something
similar happen in political economy? Is examining how the market
system handles a few small episodes of "market failure"
a good guide toward how it will handle many large ones?

As a first step toward discerning what new theories of the
new markets might look like if new visions do turn out to be
necessary, or how old ones should be adjusted, it seems sensible
to examine how enterprises and entrepreneurs are already reacting
to the fact of widespread market failure. The hope is
that experience along the frontiers of electronic commerce will
serve as a good guide to what pieces of the theory are likely
to be most important, and will suggest areas in which further
development might have a high rate of return.

1. The Market for Software (Shareware, Public Betas and More)

We noted above that the market for modern, complex products
is anything but transparent. While one can think of services,
such as medicine, which are particularly opaque to the buyer,
today it is difficult to imagine a more opaque product than software.
Indeed, when one considers the increasing opacity of products
in the context of the growing importance of services to the economy,
it suggests that transparency is and will become a particularly
important issue in the next economy.

Consumers' failure to acquire full information about the software
they buy certainly demonstrates that acquiring the information
must be expensive. In response to this cost, social institutions
have begun to spring up to get around the shrink-wrap dilemma.
The first was so-called shareware: you download the program,
if you like the program you send its author some money, and maybe
in return you get a manual, access to support, or an upgraded
version. Shareware dealt with the information acquisition problem
by turning the purchase-and-sale of software into a gift-exchange
relationship, more akin to an NPR fund raising drive. ("Is
this station worth just fifty cents a week to you? Then call...")
The benefit to try-before-you-buy is precisely that it makes
the process more transparent. The cost is that try-before-you-buy
often turns out to be try-use-and-don't-pay.

The next stage beyond shareware has been the evolution of
the institution of the "public beta." This public
beta is a time-limited (or bug-ridden) version of the product:
users can investigate the properties of the public beta version
to figure out if the product is worthwhile. But to get the permanent
(or the less-bug-ridden) version, they have to pay.

Yet a third is the "dual track" version: Eudora
shareware versus Eudora Professional. Perhaps the hope is that
users of the free low-power version will some day become richer,
or less patient, or find they have greater needs. At that point
they will find it least disruptive to switch to a product that
looks and feels familiar, that is compatible with their habits,
and their existing files. In effect (and if the sellers are lucky),
the free version captures them as future customers before they
are even aware they are future buyers.

The developing free-public-beta industry is a way of dealing
with the problem of lack of transparency. It is a relatively
benign development, in the sense that it involves competition
through distribution of lesser versions of the ultimate product.
An alternative would be (say) the strategy of constructing barriers
to compatibility: the famous examples in the computer industry
come from the 1970s when the Digital Equipment Corporation made
non-standard cable connectors; from the mid-1980s when IBM attempted
to appropriate the entire PC industry through the PS/2 line;
and from the late 1980s when Apple Computers used a partly ROM-based
operating system to exclude clones. Perhaps the main reason that
the free-public-beta strategy is now dominant is the catastrophic
failure of both IBM's PS/2 and Apple's ROM-based strategies of
exclusion based on non-compatibility--even though they were both
near-successes.

2. ShopBots (BargainFinder)

Predictions abound as to how software will use case and rule-based
thinking to do your shopping for you, advise you on how to spend
your leisure time, and in general organize your life for you.
But that day is still far in the future.(9)
So far we have only the crude prototype of the knowledge-scavenging
virtual robot, the automated comparison shopper.

Yet, the online marketplace so far has had an ambiguous reaction
to the advent of the automated comparison shopper. BargainFinder(10) is one of the first such--and
highly experimental--Internet-based agents. BargainFinder does
just one thing. Perhaps it does it too well.

The user enters the details of a music compact disk she might
like to purchase. BargainFinder interrogates several online music
stores that might offer to sell them. It then reports back the
prices in a tidy table that makes comparison shopping easy. The
system is not completely transparent: it is not always possible
to discern the vendor's shipping charges without visiting the
vendor's web site. But as BargainFinder's inventors say, "it
is still only an experiment."

Most economists, be they Adam Smithian classicists, neo-classical
Austrians, or more modern economics of information mavens, would
agree with the proposition that a vendor in a competitive market
selling a standardized product--for one Tiger Lily CD
is as good as another--would want customers to know as much as
possible about what the vendor offers for sale, and the prices
at which the goods are available.

The reason for this near-consensus is that in a competitive
market every sale at the offer price should be welcome: all are
made at a markup over marginal cost. Thus all on-line CD retailers
ought to have wanted to be listed by BargainFinder, if only because
every sale that went elsewhere when they had the lowest price
was lost profit.

Not so. A significant fraction of the merchants regularly
visited by BargainFinder were less than ecstatic. They retaliated
by blocking the agent's access to their otherwise publicly-available
data. Currently (March 1997), one third of the merchants targeted
by the BargainFinder (three out of nine) continue to lock out
its queries.(11) One, CDNow, did
so for frankly competitive reasons. The other two said that the
costs of large numbers of "hobbyist" queries were too
great for them. Meanwhile, seven additional merchants have asked
to be listed.

One possible explanation for the divergence between the economic
theorist's prediction that every seller should want to be listed
by BargainFinder and the apparent outcome is the price gouging
story. In this story, stores blocking BargainFinder tend
to charge higher than normal prices because they are able to
take advantage of consumer ignorance of cheaper alternatives.
The stores are gouging buyers by taking advantage of relatively
high costs of search.

In this case BargainFinder and its successors are indeed valuable
developments. They will make markets more efficient and lower
prices. This is entirely possible, although one need not go quite
as far as one writer who suggested that the entire world economy
is made up of such great pricing inefficiencies that the change
to an information economy will drastically reduce inflation.(12)

Another possibility is the kindly service story. Stores
blocking BargainFinder tend to charge higher than normal prices
because they provide additional service or convenience. If commerce
becomes increasingly electronic and impersonal (or if "personal"
comes to mean "filtered through fiendishly clever software
agents"), this sort of humanized attention will become increasingly
expensive. To the extent that this additional service or convenience
can be provided automatically, things are less clear.

In a sometimes forgotten classic, The Joyless Economy,
Tibor Scitovsky noted that the advent of mass production of furniture
seemed to cause the price of hand-carved chairs to increase,
even as the demand for them shrank.(13)
As consumers switched to less costly (and less carefully made,
one size-fits-all) mass-produced furniture, carvers became scarce.
Soon only the rich could engage their services. If the kindly
service story is right, the rise of the commodity market in turn
creates a risk that the economy will become yet more "joyless":
mass tastes will be satisfied cheaply as specialty tastes become
ever more a luxury.(14)

On the other hand the rise of ShopBots such as BargainFinder
offers an opportunity for consumers to aggregate their preferences
on worldwide scale. As it becomes increasingly easy for consumers
to communicate their individualized preferences to manufacturers
and suppliers, and increasingly easy to tailor goods to individual
tastes -- be it a CD that only has the tracks you like, customized
blue jeans, or a car manufactured just in time to your specifications
-- personalized goods may become the norm, putting the "joy"
back into the economy. Some signs of this were visible even before
the information revolution: lower costs of customization has
already undermined one of Scitovsky's examples, as fresh-baked
bread makes its comeback at many supermarkets and specialty stores.

In either the price gouging or kindly service stories, the
advent of BargainFinder presents CD retailers with a dilemma:
If they join in, they contribute towards turning the market for
CDs into a commodity market with competition only on price. If
they act "selflessly" and stay out, in order to try
to degrade BargainFinder's utility (and preserve their higher
average markup), they must hope that their competitors will understand
their long-run self-interest in the same way.(15)
But overt communication in which all sellers agreed to block
BargainFinder would, of course, violate the Sherman Act. And
without a means of retaliation to "punish" players
who do not pursue the collusive long-run strategy of blocking
BargainFinder, the collapse of the market into a commodity market
with only price competition appears likely.

Indeed, if the strategy was to undermine BargainFinder by
staying away, it appears to be failing. CD retailers are unblocking
BargainFinder and more are clamoring to join. Whether or not
this is an occasion for joy depends on which explanation above
is closer to the truth. The growth of the bookstore chain put
the local bookshop out of business, just as the growth of supermarkets
killed the corner grocer. Not everyone considers this trend to
be a victory, despite the lower prices. A human element has been
lost, and a "personal service" element that may have
led to a better fit between purchaser and purchase has been lost
as well.

So far, the discussion has operated on the basis of the assumption
that CD merchants would have an incentive to block BargainFinder
if they charge higher than normal prices. Strangely, some merchants
may have had an incentive to block it if they charged lower
than normal prices. As we all know, merchants sometimes advertise
a "loss leader," and offer to sell a particular good
at an unprofitable price. Merchants do this in order to lure
consumers into the store where they either may be attracted to
more profitable versions of the same good (leading, in the extreme
case, to "bait and switch"), or in the hope that the
consumer will spy other, more profitable, goods to round out
the market basket.

You can explain this merchant behavior in different ways,
either by talking about the economics of information, locational
utility, myopic consumers generalizing incorrectly on the basis
of a small number of real bargains, or about temporary monopolies
caused by the consumer's presence in this store as opposed to
another store far away. It may be that merchants blocking BargainFinder
did not want consumers to be able to exploit their loss-leaders
without having to be exposed to the other goods offered simultaneously.
Without this exposure the loss-leaders would not lure buyers
to other, higher-profit, items, but would simply be losses. The
merchant's ability to monopolize the consumer's attention for
a period may be the essence of modern retailing; the reaction
to BargainFinder, at least, suggests that this is what merchants
believe. The growing popularity of frequent buyer and other loyalty
programs also suggests that getting and keeping customer attention
is important to sellers.(16)

Interestingly, this explanation works about equally well for
the kindly service and loss leader explanations, which are the
two stories that are consistent with the assumption that the
CD market was relatively efficient before BargainFinder came
along.

3. Browsing Is Our Business (CDNow)

More important and perhaps more likely is the possibility
that the BargainFinder and other ShopBots threaten merchants
who are in the browsing assistance business. Some online merchants
are enthusiastically attempting to fill the role of personal
shopping assistant. Indeed, some of the most successful online
stores have adapted to the new marketplace by inverting the information
equation.

Retail stores in meatspace ("meatspace" being the
part of life that is not cyberspace) provide information about
available products--browsing and information acquisition services--that
consumers find valuable and are willing to pay for either in
time and attention or in cash. Certainly meatspace shopping is
conducive to unplanned, impulse, purchases, as any refrigerator
groaning under kitchen magnets will attest. Retail stores in
cyberspace may exacerbate this: what, after all, is a store in
cyberspace but a collection of information?

CDNow, for example, tailors its virtual storefront to what
it knows of a customer's tastes based upon her past purchases.
In addition to dynamically altering the storefront on each successive
visit, CDNow also offers to send shoppers occasional email information
about new releases that fit their past buying patterns.

One can imagine stores tailoring what they present to what
they presume to be the customer's desires, based on demographic
information available about the customer even before the first
purchase. Tailoring might extend beyond showcasing different
wares: taken to the logical extreme it would include some form
of price discrimination based on facts known about the customer's
preferences, or on demographic information thought to be correlated
with preferences. (The U.S. and other legal systems impose constraints
on the extent to which stores may generalize from demographic
information: for example, stores that attempt race-based, sex-based,
or other types of invidious price variation usually violate U.S.
law.).

A critical microeconomic question in all this is how consumers
and manufacturer/sellers exchange information in this market.
Both consumers and sellers have an interest in encouraging the
exchange of information: in order to provide what the consumer
wants, the sellers need to know what is desired and how badly
it is wanted; consumers need to know what is on offer where,
and at what price. A ShopBot may solve the consumer's problem
of price, but it will not tell him about an existing product
of which he is unaware. Similarly, CDNow may reconfigure its
store to fit customer profiles, but without some external source
of information about customers this takes time, and requires
repeat visitors.

Indeed, it requires that customers come in through the front
door: all the reconfiguration in the world will not help CDNow
if customers are either unaware that they would enjoy its products,
or if the customers' only relationship with CDNow is via a ShopBot.

The retail outlet in the average mall can plausibly be described
as a mechanism for informing consumers about product attributes.
The merchant gives away product information in the hopes that
consumers will make purchases. Physical stores, however, have
fixed displays and thus must provide more or less identical information
to every customer. Anyone who looks in the window, anyone who
studies the product labels, or even the product catalogs, receives
the same sales pitch.

It may be that the dynamic storefront story is the
Internet's substitute for the kindly service story. If so, then
the rise of agent-based shopping may well be surprisingly destructive.
It raises the possibility of a world in which retail shops providing
valuable services are destroyed by an economic process that funnels
a large percentage of consumer sales into what become commodity
markets without middlemen: people use the high-priced premium
cyberstore to browse, but then use BargainFinder to purchase.

To appreciate the problem, consider Bob, an on-line merchant
who has invested a substantial amount in a large and easy to
use "browsing" database that combines your past purchases,
current news, new releases, and other information to present
you with a series of choices and possible purchases that greatly
increase your chances of coming across something interesting.
After all, a customer enters seeking not a particular title,
and not a random title, but a product that he or she would
like. What is being sold is the process of search and information
acquisition that leads to the judgment that this is something
to buy. A good on-line merchant would make the service of "browsing"
easy--and would in large part be selling that browsing assistance.

In this browsing is our business story there is a potential
problem: browsing assistance is not excludable. Unless Bob charges
for his services (which is likely to discourage most customers
and especially the impulse purchaser), there is nothing to stop
Alice from browsing merchant Bob's website to determining the
product she wants, and then using BargainFinder to find the cheapest
source of supply. BargainFinder will surely find a competitor
with lower prices because Bob's competitor will not have to pay
for the database and the software underlying the browsing assistance.

If so, then projects like BargainFinder will have a potentially
destructive application, for many online stores will be easy
to turn into commodity markets once the process of information
acquisition and browsing is complete. It would be straightforward
to run a market in kitchen gadgets along the lines of the BargainFinder,
even if much of the market for gadgets involves finding solutions
to problems one was not consciously aware one had: first free-ride
off of one of the sites that provides browsing assistance to
discover what you want, then open another window and access BargainFinder
to buy it. Students and other people with more time than money
have been using this strategy to purchase stereo components for
decades: draw on the sales expertise of the premium store, then
buy from the warehouse. But the scope and ease of this strategy
is about to become much greater.

To merchants providing helpful shopping advice, the end result
will be as if they spent all their time in their competitors'
discount warehouse, pointing out goods that the competitors'
customers ought to buy. The only people who will pay premium
prices for the physical good--and thus pay for browsing and information
services--will be those who feel under a gift-exchange moral
obligation to do so: the "sponsors" of NPR.

4. Collaborative Filtering (FireFly)

Collaborative filtering provides part of the answer to the
information exchange problem. It also provides another example
of how information technology changes the way that consumer markets
will operate. In their simplest form, collaborative filters such
as FireFly,(17) bring together
consumers to exchange information about their preferences. The
assumption is that if Alice finds that several other readers--each
of whom also likes Frisch, Kafka, Kundera and Klima but gets
impatient with James and Joyce--tends to like William Gass, the
odds are good that Alice might enjoy Gass's On Being Blue
too.

In the process of entering sufficient information about her
tastes to prime the pump, Alice adds to the database of linked
preference information. In helping herself, Alice helps others.
In this simplest form, the collaborative filter helps Alice find
out about new books she might like. The technology is applicable
to finding potentially congenial CDs, news, web sites, software,
travel, financial services and restaurants -- as well as to helping
Alice find people who share her interests. Indeed, each of these
is a service currently available or soon to be offered via Firefly.

At the next level of complexity, the collaborative filter
can be linked to a shop-bot. Once Alice has decided that she
will try On Being Blue she can find out who will sell
it to her at the best price.

The really interesting development, however, comes when Alice's
personal preference data is available to every merchant Alice
visits. (Leave aside for a moment who owns this data, and the
terms on which it becomes available.) A shop like CDNow becomes
able to tailor its virtual storefront to a fairly good model
of Alice's likely desires upon her first visit. CDNow may use
this information to showcase its most enticing wares, or it may
use it to fine tune its prices to charge Alice all that her purse
will bear--or both.

Whichever is the case, shopping will not be the same.

Once shops acquire the ability to engage in price discrimination,
consumers will of course seek ways of fighting back. One way
will be to shop anonymously, and see what price is quoted when
no consumer data is proffered. Consumers can either attempt to
prevent merchants and others from acquiring the transactional
data that could form the basis of a consumer profile, or they
can avail themselves of anonymizing intermediaries who will protect
the consumer against the merchant's attempt to practice perfect
price discrimination by aggregating data about the seller's prices
and practices. In this model, a significant fraction of cyber
commerce will be conducted by software agents who will carry
accreditation demonstrating their credit-worthiness, but will
not be traceable back to their progenitors.

Thus potential legal constraints on online anonymity may have
more far-reaching consequences than their obvious effect on unconstrained
political speech.(18) In some cases,
consumers may be able to use collaborative filtering techniques
to form buying clubs and achieve quantity discounts.(19)
Or consumers will construct shopping personas with false demographics
and purchase patterns in the hope of getting access to discounts.
Business flyers across America already routinely purchase back-to-back
round trip tickets that bracket a Saturday night in an attempt
to diminish airlines' abilities to charge business travelers
premium prices. (Airlines, meanwhile, are investing in computer
techniques to catch and invalidate the second ticket.)

Consumers will face difficult maximization problems. In the
absence of price discrimination, and assuming privacy itself
is only an intermediate good (i.e., that consumers do not value
privacy in and of itself), the marginal value to the consumer
of a given datum concerning her behavior is likely to be less
than the average value to the merchant of each datum in an aggregated
consumer profile. If markets are efficient, or if consumers suffer
from a plausible myopia in which they value data at the short-run
marginal value rather than long-term average cost, merchants
will purchase this information leading to a world with little
transactional privacy.(20) Furthermore,
the lost privacy is not without gain: every time Alice visits
a virtual storefront that has been customized to her preferences,
her search time is reduced, and she is more likely to find what
she wants -- even if she didn't know she wanted it -- and this
is ever more true the more information the merchant has about
her.

The picture becomes even more complicated once one begins
to treat privacy itself as a legitimate consumer preference rather
than as merely an intermediate good. Once one accepts that consumers
may have a taste for privacy it no longer becomes obvious that
the transparent consumer is an efficient solution to the management
of customer data. Relaxing an economic assumption does not, however,
change anything about actual behavior, and the same tendencies
which push the market towards a world in which consumer data
is a valuable and much-traded commodity persist. Indeed, basic
ideas of privacy are under assault. Data miners and consumer
profilers are able to produce detailed pictures of the tastes
and habits of increasing number of consumers. The spread of intelligent
traffic management systems, video security and recognition systems
and the gradual integration of information systems built into
every appliance will eventually make it possible to track movement
as well as purchases. Once one person has this information there
is, of course, almost no cost to making it available to all.

Unfortunately, it is difficult to measure the demand for privacy.
Furthermore, the structure of the legal system does not tend
to allow consumers to express this preference. Today, most consumer
transactions are governed by standard-form contracts. The default
rules may be constrained by state consumer law, or by portions
of the Uniform Commercial Code, but they generally derive most
of their content from boilerplate language written by a merchant's
lawyer.

If you are buying a dishwasher you do not get to haggle over
the terms of the contract, which (in the rare case they are even
read) can be found in small print somewhere on the invoice. Although
it is possible to imagine a world in which the Internet allows
for negotiation of contractual terms even in consumer sales,
we have yet to hear of a single example of this phenomenon, and
see little reason to expect it. On the contrary, to the extent
a trend can be discerned, it is in the other direction, towards
the "web wrap" or "clip wrap" contract (the
neologism derives from "shrinkwrap" contracts, in which
the buyer of software is informed that she has agreed to the
terms by opening the wrapper) in which the consumer is asked
to agree to the contract before being allowed to view the web
site's content.

D. The Next Economics? (And a few policies too)

We have argued that assumptions which underlie the microeconomics
of the Invisible Hand fray badly when transported to the information
economy. Commodities that take the form of single physical objects
are rivalrous and are excludable: there is only
one of it, and if it is locked up in the seller's shop no one
else can use it. The structure of the distribution network delivered
marketplace transparency as a cheap byproduct of getting
the goods to their purchasers. All of these assumptions did fail
at the margin, but the match of the real to the ideal was reasonably
good.

Modest as they may be in comparison to the issues we have
left for another day, our observations about the microfoundations
of the Invisible Hand do have some implications for economic
theory and for policy. At some point soon it will become practical
to charge for everything on the world wide web. Whether it will
become economically feasible, or common, remains to be seen.
The outcome of this battle will have profound economic and social
consequences.

Consider just two polar possibilities. On the one hand, one
can envision a hybrid gift-exchange model, in which most people
pay as much for access to web content as they pay for NPR, and
in which the few who value an in-depth information edge or speed
of information acquisition pay more. At the other extreme, one
can as easily foresee a world in which great efforts have been
made to reproduce familiar aspects of the traditional model of
profit maximization.

Which vision will dominate absent government intervention
depends in part on the human motivation of programmers, authors,
and other content providers. The Invisible Hand assumed a "rational
economic man," a greedy human. The cybernetic human could
be very greedy, for greed can be automated. But much progress
in basic science and technology has always been based on other
motivations besides money. The thrill of the chase, the excitement
of discovery, and the respect of one's peers have played a very
large role as well, perhaps helped along by the occasional Nobel
Prize, Knighthood for services to science, or a distinguished
chair; in the future "Net.Fame" may join the list.

Government will surely be called upon to intervene. Adam Smith
said that eighteenth-century "statesmen" could in most
cases do the most good by sitting on their hands. The twenty-first
century "stateswomen" will have to decide whether this
advice still applies once the fit between the institutions of
market exchange and production and distribution technologies
has decayed.

We suspect that policies which ensure diversity of providers
will continue to have their place. One of the biggest benefits
of a market economy is that it provides for sunset. When faced
with competition, relatively inefficient organizations fail to
take in revenue to cover their costs, and then they die. Competition
is thus still a virtue, whether the governing framework is one
of gift-exchange or buy-and-sell--unless competition destroys
the ability to capture significant economies of scale.

The challenge for policy makers is likely to be particularly
acute in the face of technological attempts to recreate familiar
market relationships. Just because markets characterized by the
properties of rivalry, excludability, and transparency were efficient
does not mean that any effort to reintroduce these properties
to a market lacking them necessarily increases social welfare.
Furthermore, in some cases the new, improved, versions may provide
more excludability or transparency than did the old model; this
raises new problems.

Holders of intellectual property rights in digital information,
be they producers or sellers, do have a strong incentive to re-introduce
rivalry and excludability to the market for digital information;
the extent to which they have an interest to re-introduce transparency
regarding their wares is slightly less evident, although the
innovations we describe above in the market for software suggest
this interest is substantial also. Each of these possible developments
creates a different challenge for policy makers.

1. Increasing Excludability

It appears increasingly likely that technological advances
such as "digital watermarks" will allow each copy of
a digital data set, be it a program or a poem, to be uniquely
identified;(21) coupled with appropriate
legal sanctions for unlicensed copying, a large measure of excludability
can be restored to the market.

Policy makers will need to be particularly alert to three
dangers. First, technologies which permit excludability risk
introducing socially unjustified costs if the methods of policing
excludability are themselves costly. Second, as the example of
broadcast television demonstrates, imperfect substitutes for
excludability themselves can have bad consequences that sometimes
are difficult to anticipate. Third, over-perfect forms of excludability,(22) raise the specter that traditional
limits on excludability of information such as fair use might
be changed by technical means without the political and social
debate that should precede such a shift.

We counsel caution: In the absence of any clear indication
of what the optimum would be, the burden of proof should be on
those who argue that any level of excludability should be mandated.

2. Increasing Rivalry

It is somewhat harder to imagine how rivalry might be recreated
for digitized data without using an access system that relied
on a hardware token of some sort. Rivalry can be reintroduced
if access to a program, a document or other digital data can
be conditioned on access to a particular smartcard or other physical
object. Perhaps a cryptographically based software analog might
be developed that relied on some secret that the purchaser would
have a strong incentive to keep to herself. In either case, a
form of rivalry results, since multiple users can be prevented
from using the data simultaneously.

Imposing rivalry where it is not naturally found means imposing
a socially unnecessary cost on someone: the result may look and
feel like a traditional market, but it cannot, by definition,
be an "optimum" since this artificial rivalry ensures
that many users whose willingness to pay for the good is greater
than the (near-zero) marginal cost of producing another copy
will not get one. Policy makers should therefore be very suspicious
of any market-based arguments for artificial rivalry.

3. Increasing Transparency

It might seem that anything which encourages transparency
must be good. Indeed, all other things being equal, from the
point of view of consumers, merchants selling products that can
survive scrutiny, and the economy as a whole, increases in the
transparency of product markets are always a good thing. The
issue, however, is to what extent this logic justifies a transparent
consumer.

The answer is fundamentally political. It depends on the extent
to which one is willing to recognize privacy as an end in itself.
If information about consumers is just a means to economic end,
then there is no reason for concern. If, on the other hand, citizens
perceive maintaining control over facts about their economic
actions as a good in itself, some sort of governmental intervention
into the market may be needed to make it easier for this preference
to express itself.

4. The Next Economics?

We have focused on the ways in which digital media undermine
the assumptions of rivalry, excludability, and transparency--and
have tried to suggest that the issue of transparency is at least
as important, complicated, and interesting as the other two.
In so doing we have been forced to slight important microeconomic
features of the next economy. We have not, for example, discussed
the extent to which the replacement of human salespeople, travel
agents, and shop assistants will affect the labor market. The
consequences may be earth-shaking. For about two centuries starting
in 1800 technological progress was the friend of the unskilled
worker: it provided a greater relative boost to the demand for
workers who were relatively unskilled (who could tighten bolts
on the assembly line, or move things about so that the automated
production process could use them, or watch largely self-running
machines and call for help when they stopped) than for those
who were skilled. The spread of industrial civilization was associated
with a great leveling in the distribution of income.

But there is nothing inscribed in the nature of reality that
technological progress must always boost the relative wages of
the unskilled. And there is good reason to fear that the enormous
economies of scale found in the production of non-rivalrous
commodities are pushing in the other direction: to a winner-take-all
economy.(23)

Nor have we addressed potentially compensating factors such
as the looming disaggregation of the university, a scenario in
which distance learning bridges the gap between elite lecturers
and mass audiences, turning many educational institutions into
little more than degree-granting standards bodies, with financial
aid and counseling functions next to a gym, (just maybe) a library.
While this may benefit the mass audience, it has harmful effects
on one elite: it risks creating an academic proletariat made
up of those who would have been well-paid professors before the
triumph of "distance learning" in the lecture hall.
Consider that every Italian hill city used to provide a pretty
good living for the tenors and sopranos in the local opera, back
before the triumph of "distance listening" through
the LP, the cassette tape, and the CD. There are fewer sopranos
employed today.

Similarly, we have completely ignored a number of interesting
macroeconomic issues. Arguably, traditional ideas of the "open"
and "closed" economy will have to be rethought on sectoral
grounds. Once a nation becomes part of the global information
infrastructure, its ability to raise either tariff or non-tariff
walls against certain foreign trade activities becomes vanishingly
small. Nations will not, for example, be able to protect an "infant"
browser industry: it will be hard to enforce labor laws when
the jobs telecommute away.

National accounts are already becoming increasingly inaccurate
as it becomes harder and harder to track imports and exports.
Governments are unable to distinguish a personal letter with
a picture attached from the electronic delivery of a $100,000
software program.

Monetary economics will also have to adapt. Traditionally
the field of economics has always had some difficulty explaining
money: there has been something "sociological" about
how tokens worthless in themselves get and keep their value that
is hard to fit with economists' underlying explanatory strategies
of rational agents playing games-of-exchange with one another.
These problems will also intensify as the nature and varieties
of money changes. The introduction of digital currencies suggests
a possible return of private currencies. It threatens the end
of seigneurage, and raises questions about who can control the
national money supply.

The market system may well prove to be tougher than its traditional
defenders have thought, and to have more subtle and powerful
advantages than defenders of the Invisible Hand have usually
listed. At the very least, however, defenders of the Invisible
Hand will need new arguments to justify systems of competitive
markets when the traditional prerequisites for market "optimality"
are gone. Economic theorists have enormous powers of resilience:
economists regularly try to spawn new theories--today evolutionary
economics, the economics of organizations and bureaucracies,
public choice theory, and the economics of networks. We will
see how they do.

Notes

DeLong would like to thank the
National Science Foundation, the Alfred P. Sloan Foundation,
and the Institute for Business and Economic Research of the University
of California for financial support. We both would like to thank
Caroline Bradley, Joseph Froomkin, Hal Varian, Ronald P. Loui,
Paul Romer, Andrei Shleifer, and Lawrence H. Summers for helpful
discussions.

(11). In January 1997, BargainFinder
shopped at nine stores: CD Universe, CDnow!, NetMarket, and GEMM,
IMM, Music Connection, Tower Records, CD Land, CDworld, and Emusic.
A sample search for the Beatles White Album in January 1997 produced
this output:

I couldn't find it at Emusic. You may want to try browsing
there yourself. CD Universe is not responding. You may want to
try browsing there yourself. $24.98 (new) GEMM (Broker service
for independent sellers; many used CDs, imports, etc.) I couldn't
find it at CDworld. You may want to try browsing there yourself.
$24.76 Music Connection (Shipping from $ 3.25, free for 9 or
more. 20 day returns.) CDnow is blocking out our agents. You
may want to try browsing there yourself. NetMarket is blocking
out our agents. You may want to try browsing there yourself.
CDLand was blocking out our agents, but decided not to. You'll
see their prices here soon.IMM did not respond. You may want
to try browsing there yourself.

(14). On the other hand, retailing,
stock control, billing, auditing and shipping are different from,
e.g. manufacturing, so in principle there might still be a role
for a middleperson. Amazon.com, a leading Internet bookseller
has almost no books in stock.

(15). See Robert Axelrod, The
Evolution of Completion ().

(16).Otherwise, it would slightly
odd to find firms giving discounts to the customers who presumably
most want the merchant's wares. Perfect price discrimination
would suggest that the customers who most want the goods should
be charged the most. Of course, in a true commodity industry,
loyalty programs can also be understood as nothing more than
price competition -- i.e. discounting.

(21). For a sketch of excludability
might be constructed and maintained for digital documents, see
Brad Cox, Supxerdistribution: Objects as Property on the Electronic
Frontier (New York: Addison Wesley, 1996).

(22).See, e.g., the forms advocated
in Working Group on Intellectual Property Rights, Intellectual
Property and the National Information Infrastructure (1995).